Introduction

As long as the price is equal to or higher than average cost per unit, the firm makes a profit. But what happens if, for some reason, the price falls below the average cost per unit or the average cost increases and total revenue is less than total cost? In this case, the firm makes an economic loss.

Given a market price of P, MR = MC at point E. This occurs at a quantity of Q. At Q, the firm's average revenue (AR) per unit of production is P, which is lower than the average cost per unit C. Since AR < AC, the firm therefore makes an economic loss per unit of output, equal to the difference between C and P. The total economic loss is indicated by the area P-C-M-E.

If AR < AC, then an economic loss occurs.

Alternatively, the area representing a total loss can be obtained by subtracting the firm's total cost from its total revenue. The firm's total revenue is equal to the price of the product P multiplied by the quantity produced (and sold) Q. This is equal to the area 0-P-E-Q. The total cost of the firm is equal to the average cost C, multiplied by the quantity Q, and is represented by the area 0-C-M-Q. The difference between these two areas is the economic loss indicated by the area P-C-M-E.

Activity

Indicate whether the following statements relating to average and marginal variables is true or false:

Whenever marginal revenue (MR) is greater than marginal cost (MC), the firm is making a total profit.

Incorrect. The statement is false. When marginal revenue is greater than marginal cost, the firm is making a profit on this additional unit. It does not mean that the firm is making a total profit. For the firm to make a total profit, its average revenue must be greater than its average cost.

Correct. The statement is indeed false. When marginal revenue is greater than marginal cost, the firm is making a profit on this additional unit. It does not mean that the firm is making a total profit. For the firm to make a total profit, its average revenue must be greater than its average cost.

If a firm's average revenue (AR) is greater than its average cost (AC), it is earning a normal profit.

Incorrect. The statement is false. If a firm's average revenue (AR) is greater than its average cost (AC), it is earning an economic profit.

Correct. The statement is indeed false. If a firm's average revenue (AR) is greater than its average cost (AC), it is earning an economic profit.

If a perfectly competitive firm is earning a normal profit only, it follows that its average cost, marginal cost, average revenue and marginal revenue are all equal at the equilibrium quantity and also equal to the market price.

Correct. The statement is indeed  true. At point E, AC = MC = AR = MR = P.

Incorrect.  The statement is true. At point E, AC = MC = AR = MR = P.

If a perfectly competitive firm is making an economic loss, it implies that its average cost (AC) is greater than the market price.

Correct. The statement is indeed  true. At a point such as M, average cost (AC) is greater than the market price P.

Incorrect.  The statement is true. At a point such as M, average cost (AC) is greater than the market price P.

Study the following diagram and answer the questions:

a. At what point does the firm maximise profits?

b. What is the output level at the profit maximisation point?

c. What is the total revenue at the profit maximisation point?

d. What is the total cost at the profit maximisation point?

e. Is average cost greater, the same or smaller than average revenue at point B?

f. Is the firm making an economic profit, a normal profit or an economic loss?

Click to Show Answer

a. At point B. Profit is maximised where marginal revenue (MR) is equal to marginal cost (MC). This occurs at point B where MR = MC = R10.

b. It is 100. Profit is maximised at point B, and the output level at point B is 100.

c. It is R1 000. Total revenue is price times quantity = P x Q = R10 x 100 = R1 000.

d. It is R1 000. Total cost is average cost times quantity = AC x Q = R10 x 100 = R1 000.

e. It is the same. At point B, average cost (AC) = average revenue (AR) = R10.

f. It is making a normal profit because average revenue (AR) = average cost (AC) or total revenue (TR) = total cost (TC). The firm will make an economic profit if average revenue (AR) > average cost (AC) or total revenue (TR) > total cost (TC).

Study the following diagram and answer the questions:

a. At what point does the firm maximise profits?

b. What is the output level at the profit maximisation point?

c. What is the total revenue at the profit maximisation point?

d. What is the total cost at the profit maximisation point?

e. Is average cost greater, the same or smaller than average revenue at point A?

f. Is the firm making an economic profit, a normal profit or an economic loss?

Click to Show Answer

a. At Point A. Profit is maximised where marginal revenue (MR) is equal to marginal cost (MC). This occurs at point A where MR = MC = R10.

b. It is 100. Profit is maximised at point A, and the output level at point A is 100.

c. It is R1 000. Total revenue is price times quantity = P x Q = R10 x 100 = R1 000.

d. It is R1 200. Total cost is average cost times quantity = AC x Q = R12 x 100 = R1 200.

e. It is greater. Average cost (AC) > average revenue (AR). At point B, average cost (AC) is R12, while average revenue is R10.

f. It is making an economic loss since average revenue (AR) < average cost (AC) or total revenue (TR) < total cost (TC). The firm will make an economic profit if average revenue (AR) > average cost (AC) or total revenue (TR) > total cost (TC).